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Institutions get satisfaction with hedge funds

Megan Green and Harlan Moeckler

State Street Corporation

Q3 2006

Alternative investments have steadily gained broader appeal among institutional investors, reaching far beyond the domain of U.S. foundations and endowments which constituted the early adopters of these strategies. All signs indicate that this will continue for the foreseeable future.

The rationale behind the success of alternative investments is investor satisfaction. According to the results of a recent study conducted by State Street Corporation in conjunction with the 2005 Global Absolute Return Congress (Global ARC), institutions give alternatives an astounding 100% satisfaction rate in helping them achieve portfolio diversification. The realisation of lower portfolio volatility and increased absolute returns were key factors behind the growing role of alternative investments in institutional investors’ portfolios.

The study was conducted in October 2005. Participants represented global attendees including corporate pension plans (18%), public and government pension plans (42%), and endowments and foundations (40%). According to Global ARC, the responding institutions collectively manage more than $1 trillion total assets in their investment portfolios. Other conference attendees, including asset managers, consultants and service providers, were not eligible to participate.

Increasing hedge fund holdings

Among its key findings, the study confirmed that institutional investors continue to increase their allocation to alternative investment vehicles. Nearly half of institutional investor respondents have 10% or more of their portfolios invested in hedge funds today. This represents an increase over results of State Street’s 2004 study, when just over a third of respondents said hedge funds represented 10% or more of their assets.

Figure 1: Percent of portfolio allocated to hedge funds

For the first time, State Street also questioned respondents about the role of private equity in their portfolios. While fewer than a quarter of respondents had more than 10% of their portfolio invested in private equity, nearly half had allocated up to 5% and almost a third held between 5% and 10% of their portfolio in private equity assets.

Figure 2: Percent of portfolio allocated to private equity

Most respondents indicated that these new allocations to both hedge funds and private equity will be at the expense of existing active and passive equity allocations, as was also found in the 2004 study.

Growing Comfortable With alternatives

The vast majority of respondents (81%) indicated that their investment boards and trustees are more comfortable with hedge funds than they were 12 months ago. These same boards also devote significant energy to alternative investments—more than half reportedly spend in excess of 15% of their time discussing these assets, primarily to evaluate new strategies and review existing managers.

Respondents all said hedge fund investments have met their expectations for portfolio diversification. Well over half also reported they were satisfied with the results of hedge funds in lowering volatility and raising the absolute return of their portfolio.

Figure 3: Hedge fund results vs expectations

Adding alternative managers

Most institutional investors indicated that they plan to add new hedge fund managers to their line-up and two-thirds said they will hire more private equity managers in 2006. Almost half of survey respondents said they currently engage more than 10 direct hedge fund managers, and about as many said they invest with up to three fund of hedge fund managers. Nearly a third said they do not invest in fund of funds. On the private equity side, most said they utilise more than 10 managers.

Figure 4: Number of direct hedge fund managers used

Figure 5: Number of FoF managers used

Figure 6: Number of private equity managers used

When asked to profile the most desirable attributes for a prospective manager, the respondents said managers most likely to be selected would have the following attributes:
• At least $200 million assets under management
• At least a one-year track record
• An independent administrator strikes their fund’s NAV
• They charge fees of 2 and 20
• They are willing to negotiate their ‘terms’

Separating alpha and beta

The results of this study also illustrate institutional investors’ growing appetite for distinguishing their managers’ performance in terms of alpha and beta. The vast majority of respondents said they selectively engage new managers for both alpha and beta, while only 59% said they were able to differentiate between these results.

For those respondents who said they could not separate a given manager’s alpha and beta results, 82% attributed this inability to a lack of tools and resources. Half of investors surveyed also said they do not use alpha porting techniques.

Figure 7: Separating alpha from beta

There is clearly a growing appreciation for distinguishing alpha from beta returns. Consequently, institutional investors are becoming more sophisticated in how they engage, compensate and monitor the performance of their asset managers. These asset managers will continue to be pressed not only to deliver absolute returns, but to substantiate their true alpha contributions.